Risky bets with investor cash

The issue of promoters pledging their shares to raise money through their private firms and group companies has long been plaguing the markets. Many a time individual stocks have been hammered when promoter shares were sold in the market as the value of the collateral fell.

Markets do not always have the capacity to absorb large deals and in panic prices fall further, eroding investor wealth. Equities, one can argue, are inherently risky and volatile. But in recent months, debt instruments turned risky too and the affected were mutual funds saddled with promoter shares as collateral that they couldn’t immediately sell.

SEBI has made it tougher for mutual funds to lend against shares. It hiked the cover required for loans against shares to four times the loan value. Fund houses may complain, but there is no denying the fact that they were taking a risky bet with investors’ money. The AAA ratings of the company whose shares act as collateral for loans to the promoters can be a mirage as value erosion in equities can be drastic during a market downturn.

Promoters raised money through debentures issued from their privately held companies with shares of their publicly traded companies as collateral. Most of these private firms lack independent revenue streams to service the loans. The RBI in its latest Financial Stability Report observed, “debt instruments backed by equity shares have a downside that is akin to that of a short put option on the underlying shares”.

High leverage looks all fine when markets enjoy abundant liquidity, but would come to bite when that dries up.  The RBI report also said the high level of pledging by promoters is seen as an indication of the poor health of the company and probably its inability to raise funds through other means. SEBI has also tweaked disclosure requirements for promoter share pledge. It is up to companies and regulators to ensure compliance in the interest of the investors. It would be prudent if promoters exercised restraint to not over-leverage, and lenders acted responsibly.